Tax Strategies You Can Grow into Based on Your Long-Term Goals, Part Two
Captive insurance companies give you control of your risk financing – with substantial tax advantages
Business owners too often take a passive approach to tax planning – only thinking about taxes once April approaches or quarterly payments are due. But as your business thrives, the only way to avoid unnecessarily painful payouts to Uncle Sam is by proactively creating a long-term strategic tax plan.
In this second installment of our series on long-term tax strategies, we explore how captive insurance companies can help you achieve your financial goals.
Captives were mostly unaffected by the new Tax Cuts and Jobs Act of 2017, and an experienced certified public accountant can help you weave them into a thoughtful long-term strategy that minimizes your tax liability as your company enters new stages of growth.
What is a captive insurance company?
Captive insurance is a form of self-insurance where the insurance company is owned by the people it ensures. But unlike mutual insurance companies, which are also owned by their policyholders, captive insurance companies are both owned and controlled by policyholders who put their own capital at risk in exchange for the financial benefits that come with better control of their insurance program.
Captives are typically established as wholly-owned subsidiary companies that mitigate business risks for a parent company or a group of related companies. They are most often formed if the parent company can’t find a third-party insurer to protect it against certain risks, if the premiums paid to the captive provide tax benefits, or if the insurance a captive can offer is more affordable or offers broader coverage for the parent company’s risks. Construction or professional services companies, for example, often find captive insurance appealing.
Here’s why: By decreasing payments to third-party insurance companies and supporting the captive program instead, the money the company pays accrues for the benefit of the owners – creating investment income in a tax-preferred way. The main goal of captive insurance is risk management, but a welcome side benefit is that businesses will profit if claims are less than the premium because underwriting profits and excess reserves are returned to the parent company.
Insurance premiums paid by a company to the captive are also tax-deductible. And since insurance companies are subject to special tax rules, a captive can claim deductions for loss reserves that open the door to tax deferrals. Some programs even qualify to exclude all insurance profits from taxable income.
Put simply, if a company is spending six figures on insurance but has a good claim history, it could easily take control of its risk financing through a captive program. It’s essentially building a war chest to fight its way out of tough situations, but the war chest may eventually be used for other things in the core business – if no catastrophes occur.
Captive insurance programs have been used by Fortune 500 businesses for decades, but new efficiencies are making them cost-effective for smaller companies as well. Today, more than 6,000 captive insurers exist, with more than 40 percent of major U.S. corporations owning one or more captive insurance companies.
Biggest tax benefits
- The insurance premium paid by the parent company to the captive is completely tax-deductible but doesn’t count as income to the captive, thus reducing the parent’s marginal tax rate.
- An opportunity to build wealth in a tax-preferred manner.
- Distributions to the captive’s owners are paid at favorable income tax rates.
- The ability to deduct a “reasonable and fair” loss reserve, meaning the number of reserves available to invest will not be decreased by taxes.
- State premium taxes that would have been paid in a commercial insurance program may be lowered.
- Business owners have a lot of flexibility when it comes to a captive’s ownership structure, and that can lead to invaluable estate planning benefits. If a captive is owned by a business owner’s children or other heirs, they can transfer large amounts of wealth to them free of gift and estate taxes.
One caveat: There can be gift tax consequences if the captive owners receive their shares as gifts, but otherwise, they can reap rewards from the captive’s growth free of transfer taxes.
A few more caveats
- For the most part, all captive insurance companies taxed in the U.S. will benefit from the new tax law. Since all insurance companies are C corporations, large captives will see their underwriting profits reduced from as high as 35 percent to a flat 21 percent tax rate.Tax on investment income will be reduced to 21 percent as well. Small captives – receiving annual premiums of $2.3 million or less – will continue to be taxed at 0 percent on their underwriting profits but will also see their investment income tax rate drop to 21 percent from as high as 35 percent in previous years.
So, what’s the catch? The tax benefits captives provide may be reduced – but not eliminated – as the new tax law decreases parent company taxation for most businesses. The impact will vary from company to company and is best explained as a possible reduction in the tax arbitrage between the captive and parent.
- Captives need to be set up and managed properly to avoid IRS scrutiny. The IRS may challenge premium deductions if it believes the company is focused only on the deduction instead of actuarially-sound practices. Due to abuse of the program, captive insurance was included among the “abusive tax shelters” on the 2017 IRS “dirty dozen” list of tax scams.Among the abuses listed are premium amounts that are significantly higher than premiums for comparable commercial coverage, unsupported by underwriting or actuarial analysis, or simply geared toward the desired deduction amount.
- Captive insurance companies can be expensive to create – including fees to actuaries, attorneys, and an insurance expert – and government compliance can be tricky to navigate. Once established, the captive operates like any commercial insurance company subject to regulatory mandates, including reporting, capital, and reserve requirements.A qualified CPA is best suited to help you determine if the tax and other benefits outweigh the initial costs.
The new tax code makes taxes more complicated than ever – and that also makes the benefits of long-term strategic tax planning more valuable than ever before. Once a hallmark of Fortune 500 companies, today, even small businesses are taking advantage of the many tax, financial, and estate planning benefits captive insurance programs can offer.
But while captives can provide substantial tax savings as your company grows, they are not the right fit for every business. An experienced CPA can help you determine if captives can help your company meets its goals and fold them into a long-term strategic tax plan that propels your business along the path toward success.
Provident CPA & Business Advisors serves successful professionals, entrepreneurs, and investors who want to get more out of their business and work less, so they can make a positive impact on their lives and communities. Typically, our clients reduce their taxes by 20 percent or more and create more tax-free wealth for life. Contact us for expert advice on the new tax code, and to find out how we can help your business exceed your expectations.